Estimating Relative Tax Efficiency for Selected States in India: An Error Correction Approach

We estimate state-level tax efficiency in India using an error correction framework, making a distinction between a long-term cointegrating relationship and a short-term dynamics around it. We use a stochastic frontier approach in a panel data framework considering 17 medium and large (ML) states for the period 2004–2005 to 2019–2020. We find that the FC14’s initiative to sharply increase the states’ share in the divisible pool of central taxes had an adverse impact on states’ own tax revenues. The short-term relationship converges to the long-term relationship in 2.6 years. In terms of relative tax effort, the most efficient state was Tamil Nadu, while the least efficient was Bihar. Results from this study would be useful in averting the problem of adverse incentives, while determining the intergovernmental transfers. In the post-GST scenario, operating at their tax efficiency frontier would be critical for states especially in the light of discontinuation of the GST compensation cess.